Netflix – A Brutal Lesson On the Dangers of Overvaluation

The stock market has been pummeling Netflix (NFLX), assumingly based on significantly lowered expectations of future earnings results. However, the purpose of this article is not to provide a comprehensive analysis of Netflix the business. Many fine articles have recently been published that have covered the business potential of Netflix more than adequately. Whether Netflix (NFLX) is a good or bad investment going forward is not our focal point. Instead, the purpose of this article is to focus on the important lesson of valuation that Netflix is currently teaching those with the foresight and an open mind to learning.

Therefore, we would like to point out that most of Netflix’s poor stock price performance over the past 18 months can be attributed to the stock becoming significantly overvalued starting in the summer of 2010 and continuing until late July 2011. We argue that since the stock was priced to perfection, it was very vulnerable to even the slightest whiff of bad news. The following analysis through the lens of F.A.S.T. Graphs™ provides a vivid pictorial expression of our overvaluation thesis.

Graph Number One: Netflix’s Exceptional Earnings Growth

With our first graph, we plot Netflix’s earnings per share growth (orange line) since calendar year 2007. At the bottom of the graph you will see that earnings grew from $.94 in 2007, to $1.43 in 2008, to $2.05 in 2009, to $3.06 in 2010, and earnings are estimated, based on management’s most recent guidance, to be approximately $4.03 by year-end 2011. To the right of the graph we learn that Netflix’s average earnings growth rate since 2007 was an exceptional 39.2% (see red circle).

Graph Number Two: Netflix with Price Correlated to Earnings

With graph number two we add two very important lines. First, we add the normal price earnings ratio that the market had historically applied to Netflix. The normal PE ratio for Netflix calculated out to be 29.6, which is almost twice the normal PE ratio of 15 which is applied to the average company. On the other hand, Netflix’s exceptional earnings growth justified this level of premium valuation. Nevertheless, starting in March of 2010 the black price line began to move above the blue normal price earnings ratio line before peaking in late July.

We believe this painted a very clear picture of overvaluation, and we first wrote about it in November of 2010.

We argued that this profitable enterprise had become dangerously overvalued. At the time of that writing Netflix was trading at $223.20 and it continued rising to over $304 by late July, effectively becoming more and more overvalued with each passing day. However, by the end of July the rubber began meeting the road and Netflix’s stock price was quickly reverting to the mean which it clearly reached on September 30, 2011.

However, recent earnings guidance of a few quarters worth of losses has dramatically altered expectations of future earnings. Consequently, the market is attempting to establish a new and lower mean. Time will tell where this ends up, however, most likely Netflix will go much lower.

Avoiding the Obvious Mistake

Based on the undeniable relationship between earnings and market price, investing in Netflix when it was so massively overvalued, even when expectations about future earnings growth were still very high, represented an obvious mistake that could have, and should have been avoided. Mathematically, it should have been clear that Netflix’s earnings and cash flow did not support their lofty valuation.

Although it’s true that speculators and/or momentum investors could have bought Netflix in early 2011 and made a very high rate of return by summer, assuming of course that they then sold, that action cannot be properly described as investing. Later in this article we will discuss the difference between investing versus speculating more fully.

Netflix: A Lesson On the Differences Between Investing and Speculation

We believe the real differences between investing and speculation relate to what the investor/speculator is focusing on. Speculators are mainly concerned with the short-term movement of stock prices, and in that vein are looking for ways to predict those movements. Investors, on the other hand, hold a longer-term view and, therefore, tend to be more interested in determining the value of the underlying business behind the stock.

Regarding our F.A.S.T. Graphs™ research tool, it was designed to assist us, as prospective investors, in determining what we call the True Worth™ of any business we use F.A.S.T. Graphs™ to analyze. From this perspective, we see it as a way to assist us towards making sound long-term investment decisions, based on the opportunity to receive a level of future cash flows (earnings) that adequately reward us for the risk we assume.

Therefore, it is business valuation, not the stock price that drives our decisions. Our focus is on the past, present, and most importantly, the future cash flows that we believe the business is capable of generating on our behalf. Since our philosophy is predicated on the notion that earnings determine market price, we trust that the appropriate future stock price will inevitably manifest. Netflix is a recent case illustrating that our trust has been properly placed.

The important point here is that we see stock price as an afterthought, and not our primary focus or interest. Some would refer to what we do as market timing, but we vehemently disagree. What many refer to as market timing, we instead see as determining intrinsic value. It is true, that we will not invest if we believe that the marketplace is currently overvaluing a company we are interested in. But we have no opinion as to where the price might go in the short run. If we believe the market is pricing the stock too high, we simultaneously ascertain that it is too risky an investment for us to allocate our capital into.
In an attempt to clarify our position, we would like to point out certain stock-price behaviors on a well-known company that we have written about before, Wal-Mart. For example, from 1997 to 1999, Wal-Mart (WMT) became progressively more overvalued each year until it peaked in 1999. From there it took almost eight years for its price to return to our definition of intrinsic value. In other words, for eight years the stock went mostly sideways before it finally returned to our earnings justified valuation level. Eight years is an extremely long period of time in which to try to time a market, however, the principle behind valuation held true. (Here is a link to a recent article were we covered Wal-Mart)

We simply did not invest in Wal-Mart during that time period because we believed that Wal-Mart’s cash flows did not justify its valuation.
The point we are attempting to make, is that we have learned that attempting to time the market is an exercise in futility. As the legendary financier Bernard Baruch so aptly put it, “Don’t try to time the market, because it can only be done by liars.”Choosing not to invest in a company because its price does not reflect sound business value is not, in our opinion,